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What is the impact of heightened uncertainty on future monetary policy steps?

July 13, 2017

We believe that the economic environment will continue to be disinflationary and we expect the Copom to cut the Selic rate

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• In this note, we use the distinction between the short-term and long-term neutral interest-rate concepts to analyze the recent communication from the BCB and to evaluate the impact of heightened uncertainty on monetary policy.

• The analysis suggests that the uncertainty regarding the reforms, particularly the pension reform, favored a steepening of the interest-rate curve by raising the long-term neutral interest rate (via reduction of domestic savings in the long run), but reducing the short-term neutral rate (due to a decline in confidence).

• The uncertainty shock also has a potential inflationary effect, by way of de-anchoring inflation expectations and currency depreciation. So far, however, such impacts seem contained.

• In the relevant horizon for monetary policy, the short-term neutral rate guides the equilibrium of the economy. The reduction of this rate, coupled with well-anchored inflation expectations and a well-behaved exchange rate, corroborates our view that the Copom will continue to cut the Selic rate toward our forecasts of 8.0% by the end of 2017 and 7.5% by the end of 2018.

The neutral interest rate is generally defined as the interest rate that would be consistent with output at its potential level and, consequently, the inflation rate at the target (assuming a credible inflation-targeting regime)[1]. This concept can be used to characterize the monetary-policy stance over time: when the policy rate stands below its neutral level, monetary policy will be expansionary, stimulating aggregate demand and leading to a positive economic-activity gap (i.e., an above-potential GDP) and to an above-target inflation rate. On the other hand, if the policy rate stands above the neutral level, monetary policy will be contractionary, reducing aggregate demand and thus leading to a negative output gap and below-target inflation.

These relationships can be seen in Figure 1, which shows the curve that relates the interest-rate level to the output-gap level, the so-called IS curve. The point E0 determines the neutral interest rate, that is, the rate that corresponds to a zero output gap and, consequently, assuming a credible monetary policy and the absence of shocks, inflation at the target.

In practice, the use of the neutral interest-rate concept is limited by the fact that this rate is not observable and is difficult to estimate in real time. For this reason, Blinder (1998) argues that the neutral interest-rate concept is more useful as a way of thinking about monetary policy than as a mechanical rule for the central bank’s actions.

Based on this way of thinking about monetary policy, we analyze below the current standing of the Brazilian economy and the recent communication of the BCB’s Monetary Policy Committee (Copom). To that end, it will be particularly useful to distinguish between the long-term and the short-term neutral rates, as described by Bernhardsen and Gerdrup (2007) and explored in the Brazilian case by Goldfajn and Bicalho (2011).

The long-term and short-term neutral interest rates

The neutral interest rate is determined by the balance between savings and investment[2]. Long-term and short-term neutral interest rates may differ because, in the short term, there are disturbances that affect the economy on a temporary basis. In particular, positive (negative) deviations from the equilibrium of factors that autonomously affect aggregate demand – such as world GDP, government spending, earmarked credit, the degree of financial health of corporations and households and the real exchange rate, among others – tend to increase (decrease) the interest rate that promotes equality between the actual and potential output. Therefore, the short-term neutral interest rate tends to oscillate around the long-term neutral interest rate as a result of such disturbances, as shown in Figure 2.

In the Brazilian case, the distinction between the short-term and long-term neutral interest-rate concepts is useful to analyze the impact of the recent uncertainty shock on the conduct of monetary policy.

The impact of the uncertainty shock on the conduct of Brazilian monetary policy

In its recent communication, the Copom highlighted the ambiguous potential impact on inflation of the uncertainty shock recently experienced by the Brazilian economy. In particular, the Copom has pointed out that[3]:

“if sustained over a long period, high levels of uncertainty regarding the evolution of reforms and adjustments in the economy can have detrimental effects on economic activity, and hence be disinflationary”

“the impact of uncertainty on price setting and on estimates of the structural interest rate may have the opposite direction (inflationary)”

Increased uncertainty regarding the approval of the pension reform may have an impact on the future path of government spending, which would shift the IS curve upwards in the long run[4]. As a result, the long-term neutral interest rate would shift from point E0 to point ELT and, all other variables kept constant, there would be less room for the economy to operate at low interest rates permanently. In other words, the maintenance of the interest rate at the lower previous neutral level (E0) would, in the long term, lead to an economic rebound, and consequently have an inflationary impact (Figure 3).

In the relevant horizon for monetary policy, however, the short-term neutral interest rate is the one that guides the equilibrium of the economy. The political-uncertainty shock has a negative impact on aggregate demand. After all, greater uncertainty reduces the confidence of economic agents and leads to the postponement of investment plans, and may negatively affect the consumption of durable-goods as well. As a result, the IS curve shifts downward for some time (for the same E0 interest-rate level, the output gap is wider), bringing the neutral interest rate to a lower level in the short term, EST (Figure 4). In this case, the interest rate at the previous neutral level (E0) would become contractionary and, consequently, would have a disinflationary impact.

The disinflationary impact resulting from the decline in activity, however, may be partially offset or even annulled if a deterioration in the perception of the fiscal trajectory leads to sharper currency depreciation and/or de-anchoring of inflation expectations. This would be represented by an upward shift in the Phillips curve, which relates the inflation rate to the output gap. At point E0, inflation is at the target. The new equilibrium could be reached with an inflation rate above (point A) or below the target (point B), depending on the magnitude of the upward shift of the Phillips curve (Figure 5) and the size of the recessive shock.

Thus, the final effect of the uncertainty shock on the inflation scenario will depend on the magnitude of the downward shift of the short-term IS curve and the magnitude of the upward shift of the Phillips curve. On the other hand, the inflationary impact resulting from higher estimates of the structural interest rate is only valid in the long term, and not in a horizon that is relevant for monetary-policy.

After all, is the shock inflationary or disinflationary?

The analysis of the latest Focus survey data helps answer this question.

Forecasts for GDP growth in 2018 fell from 2.5% in early May to 2.0% by the end of June. The immediate negative impact of the uncertainty shock on economic-activity forecasts corroborates the thesis that the short-term IS curve shifted downward in the short run.

On the other hand, long-term inflation expectations (3 years) – a proxy for the market’s perception of the target actually pursued by the BCB – remain well anchored and the exchange-rate forecasts remain well behaved, despite the increase in uncertainty. Therefore, the upward shift of the Phillips curve does not seem to have been large enough to offset the downward shift of the IS curve (we are probably closer to point B of Figure 5 than point A).

In practice, this implies that the BCB would be able to continue the easing cycle, with relatively contained risks of short-term inflationary pressures.

Conclusions

The ambiguous effect of the uncertainty shock on inflation stems from its distinct impacts on the short-term IS curve and on the Phillips curve.

The long-term interest rate tends to be higher, given the perception of lower savings in the long run, which would be a consequence of a weakened fiscal-reform agenda, including the pension reform. In addition, an eventual non-implementation of the new TLP to replace the TJLP may also lead to higher long-term interest rates. This is because earmarked credit offered at subsidized rates, such as TJLP, tends to pressure up interest rates on non-earmarked credit, so that total demand for credit remains at a level compatible with the availability of savings.

In the relevant horizon for monetary policy, however, the short-term neutral interest rate is the one that matters. Given the immediate negative impact on aggregate demand, the IS curve shifts downward, generating a disinflationary environment at first.

The inflationary risk in this context stems from the possibility of a fiscal deterioration that is large enough to affect inflation expectations over longer horizons as well as the exchange rate (i.e., a sharp upward shift of the Phillips curve). This, however, is not our baseline scenario and is not what the market expects, at least for now, as shown by the Focus survey.

We therefore believe that the economic environment will continue to be predominantly disinflationary, and we expect the Copom to continue to cut the Selic rate toward our forecast of 8.0% by the end of 2017 and 7.5% by the end of 2018.

[2]Traditional economic theory (Ramsey, 1928) states that factors such as productivity, population growth and propensity to save influence such equilibrium. Intuitively, a greater propensity to save increases the availability of resources to meet investment, which lowers the interest rate that balances savings and investment. On the other hand, higher potential growth, as measured by productivity and population growth, means a higher marginal return on investment, which raises the interest rate that balances savings and investment.

[3]Inflation Report as of June 2017 and Minutes of the Meeting held on May 30 and 31, 2017.

[4]If the pension reform is not approved, government spending will be higher in the long term.